Stéphane Renevier, CFA

4 months ago7 mins

Warren Buffett Loves Japan. Your Portfolio Might Love It Too.

Warren Buffett Loves Japan. Your Portfolio Might Love It Too.

Stéphane Renevier, CFA

4 months ago7 mins

Warren Buffett Loves Japan. Your Portfolio Might Love It Too.
  • Japanese stocks are rallying and there are four solid reasons to consider getting on board: corporate reforms could uplift earnings and valuations, the macro picture looks increasingly positive, flows could give an extra boost, and there’s a potential benefit from the geopolitical tensions.

  • But Japan’s stocks have had their share of false rallies in the past 30 years, and there are reasons to be skeptical about the current rise: inflation and reforms may fizzle out, the unsexiness of this stock market may limit flows, and a global recession could hurt these companies.

  • Overall, a strong case could be made to own Japanese stocks in your long-term portfolio: they give you something different than US stocks, and the upside could be interesting if the stars align.

Japanese stocks are rallying and there are four solid reasons to consider getting on board: corporate reforms could uplift earnings and valuations, the macro picture looks increasingly positive, flows could give an extra boost, and there’s a potential benefit from the geopolitical tensions.

But Japan’s stocks have had their share of false rallies in the past 30 years, and there are reasons to be skeptical about the current rise: inflation and reforms may fizzle out, the unsexiness of this stock market may limit flows, and a global recession could hurt these companies.

Overall, a strong case could be made to own Japanese stocks in your long-term portfolio: they give you something different than US stocks, and the upside could be interesting if the stars align.

Warren Buffett’s big bets tend not to stay quiet for long, like the fact that Berkshire Hathaway now has more exposure to Japan than any country other than the US. That wager – staked on the expectation that Japanese stocks might finally be entering a new chapter – is helping to drive Tokyo’s stock market straight into investor focus, catapulting it to highs not seen since July of 1990. And this could be just the dawn: they don’t call it the land of the rising sun for nothing.

Four big reasons to like Japanese stocks now.

An improving corporate environment could uplift earnings and valuations

For years, Japanese companies have sported the “not-so-cool” tag – think: lousy returns on equity, stingy cash distributions to shareholders, and a tortoise-like pace on change.

Unsurprisingly, that’s led Japanese companies to trade at a steep discount relative both to their own valuation history and that of their US peers. In fact, here’s a shocker: about half of Japanese stocks are currently trading for less than their book value.

Based on their 12-month forward price-to-earnings (P/E) ratio, Japanese stock valuations look cheap, compared to US stocks, global stocks, advanced country global stocks, as well as compared to their own history.
Based on their 12-month forward price-to-earnings (P/E) ratio, Japanese stock valuations look cheap, compared to US stocks, global stocks, advanced country global stocks, as well as compared to their own history.

All of this may be about to change. Buffett’s big bet on the world’s third-biggest economy shows there may be more than meets the eye with Japanese companies. That is to say: these companies aren’t simply cheap, many are high-quality too. And thanks to some sweeping corporate governance reforms, which are pushing for shareholder-friendly strategies, they may be about to unlock all that value. In fact, the corporate governance revolution seems to be gaining serious traction: record-breaking buyback announcements rocked the fiscal year of 2022, and this year just might topple that. Activist funds are mushrooming too, pushing the corporate heavyweights to bring their A-game and boost profitability.

What’s more, the Tokyo Stock Exchange has recently promised to “enhance the corporate value of each listed company”, threatening penalties for companies trading below their book value and cheering on those who are upping their corporate worth. These aren’t just cosmetic changes and unlocking value will take a minute, but it’s starting to feel like the dawn of a new era for corporate Japan. This is one of the reasons why Japanese stocks seem to be pushing skyward.

The Japanese stock market has finally broken higher, hitting highs not seen since 1990. Source: Financial Times.
The Japanese stock market has finally broken higher, hitting highs not seen since 1990. Source: Financial Times.

The macro picture is turning more positive.

For a quarter of a century, Japan was trapped in a deflationary spiral, with its hottest inflation topping only 1% and only briefly, at that, in two short-lived stints. This was tricky: falling or flat prices led consumers to hold back on purchases, made the country’s debt burden weightier in real terms, ate into corporate profits, and hampered central bank policy. But times, they are a-changing: this past April saw a hearty 3.4% surge in core inflation, compared to the previous year, and has stayed above the Bank of Japan’s 2% long-term target for over a year now. And with wages now rising, consumer and corporate actions could soon shift. This could spark higher spending levels without sending the central bank into a tizzy of interest rate hikes. Compared to most other places on the globe, Japan’s inflation seems to be striking a nice balance.

In terms of economic growth, Japan might not exactly be breaking the bank, but it’s pretty lofty compared to the advanced economies that’ve been playing footsie with recession risks. Thanks to its Johnny-come-lately approach to lifting pandemic restrictions, Japan is set to reap the rewards of newly boosted consumer spending and tourism. We’ve had a sneak peek already: economic growth surpassed economists’ conservative 0.7% forecasts in the first quarter, with a rowdy 1.6% increase.

This promising blend of inflation and growth is welcome news, not just for foreign investors who are nervously eying stagflation (that very bleak combo of low growth and high inflation) at home, but also for Japanese households. With a mere 10% of their considerable assets tied up in stocks (compared to Europe’s 20% and the US’s staggering 40%) – and the rest mostly held in low-yielding currency and deposit accounts – any shift from cash to stocks could stir significant buying momentum.

Big money may be about to flow in.

Although the past few weeks have seen fund inflows from foreign investors, that’s not been the case for a fairly long time. In fact, over a longer time frame, foreign investors have been net sellers of Japanese shares by a considerable margin. And a recent Bank of America survey shows that investors – whether retail ones or big institutional ones – are still heavily underweight in Japanese assets, relative to their normal allocation to the country.

As for the latest uptick, it’s coming from macro investors using futures, rather than from long-term stock-picking investors. All that points to one thing: there’s a lot of room for flows to pick up in earnest. And the more momentum Japanese stocks get, the bigger the impulse is likely to be.

Flows have picked up recently, but Japan remains underloved. Sources: Goldman Sachs and Japan Exchange Group.
Flows have picked up recently, but Japan remains underloved. Sources: Goldman Sachs and Japan Exchange Group.

And these could be the cherry blossom on top.

Other factors are also supportive. For one thing, Japan may potentially become the “new best friend” of supply chains (word has it that top chipmakers TSMC, Samsung, Micron, and Intel might bring manufacturing back to Japan, in part because of global security concerns). For another, Japan is just a safer play – albeit an indirect one – on China, which is still its top trading partner. Thanks to its deep markets, blue-chip firms, and lower political risk, Japan remains one of the safest ways to bet on Asia.

And at least as many reasons to be cautious.

Japan’s stocks have had their share of false rallies in the past 30 years. Thrilling bull markets have emerged, only to fizzle out. With this in mind, skepticism about the current rally is valid.

First, inflation is a big part of what’s driving these moves and it could dwindle. Producer prices have been falling and services inflation (aside from tourism) has been mild. Sustainable, stronger wage increases would be needed to keep inflation from falling back toward zero and that’s been a tough row to hoe for Japan (although the early signs are hopeful).

Second, corporate reforms might fall short. Japan’s rallies tend to blaze brightest when a pro-reform government is in play, but even Shinzo Abe’s “three arrows” economic reforms a decade ago saw the buzz fade fast. Expectations around the current reforms are high, but more evidence is needed to really get investors excited.

Third, Japan’s stock market remains pretty unsexy: it’s dominated by companies in dying industries (old-school autos, anyone?) and lacks the innovative ones that make US stocks so appealing. So it may prove difficult to convince investors to make a more significant allocation to Japan in their portfolio.

Fourth, Japanese firms’ exposure to global economic growth could be a double-edged sword if the threat of a sharp recession materializes. If China’s reopening bounce flattens or the US slips into recession, Japan could find itself on shaky ground.

Fifth, a potential monetary policy shift by the BoJ – like a tweak to its yield curve control policy – might introduce volatility and scare investors.

And, last, but not least, there’s the ever-present headwind created by the country’s aging population and low birth rate, which are putting downward pressure on demand.

So what’s the opportunity?

Truth be told, Japan mightn’t be shouting “once-in-a-lifetime opportunity”, even if Buffett is on board with it.

But that doesn’t mean you should overlook it as a compelling long-term investment prospect, either. With low starting valuations and improving cyclical and structural drivers, its companies may be in a good position to expand their margins, benefit from rising valuations, and grow their revenues by more than the market expects. Put more simply, they may have the potential to deliver high returns, potentially higher than in regions that are currently favored by investors (like the US).

More importantly, it offers your portfolio something different and may be a valuable complement to your US stock holdings. In uncertain times, diversifying across different regions may be one of the most sensible things you can do.

For a long-term bet, you might consider the Franklin FTSE Japan ETF (ticker: FLJP; expense ratio: 0.09%): it’s very cheap, it’s well-diversified, and it’s liquid enough. Or, if you don’t want to be exposed to currency fluctuations, you might consider the WisdomTree Japan Hedged Equity Fund (DXJ; 0.48%) instead. Just be aware that you’d miss out on gains if the yen rises in value – which is a real possibility given how much it’s depreciated.

On the other hand, if you prefer to pick individual stocks, have a look at the following screen from Goldman Sachs, which tries to identify companies most likely to benefit from Japan’s corporate governance reforms.

Stocks with low price-to-book ratios in industries most likely to receive a boost from reforms. Source: Goldman Sachs.
Stocks with low price-to-book ratios in industries most likely to receive a boost from reforms. Source: Goldman Sachs.

Then again, you could simply choose to follow the Oracle of Omaha’s lead and buy some of the stocks he owns himself: Mitsubishi, Mitsui, Marubeni, Sumitomo, and ITOCHU.

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